In this article, we will discuss Hedge Fund vs. Private Equity. Private equity can be defined as investors’ funds to acquire listed companies or invest in private equity companies. On the other hand, a hedge fund can be defined as a private entity that raises investors’ funds. Then invest it back into financial instruments with a complicated investment portfolio. Although the investment profiles of hedge funds and private equity funds are similar, the investment objectives and types sought by hedge funds and private equity funds are significantly different.
Hedge funds and private equity funds attract these high-net-worth individuals. Their minimum investment must reach 1,000,000 US dollars or more, but the investors must be less than 100 people. Traditionally, it is a limited partnership, which involves paying a basic management fee and a certain percentage of profits to the managing partner. The key is that hedge funds are alternative investments. They use pooled funds and various strategies to help investors obtain high returns. Private equity funds invest directly in companies by purchasing controlling shares of private companies or listed companies. In private equity, a prospectus is provided to investors who have shown interest in financing businesses. Hedge funds are established as limited liability companies to protect investors and managers from lenders, provided that these funds have gone bankrupt.
Definition of Hedge Fund
The term hedge fund was developed in the early 1940s and 1950s. Compared with the general market, hedge funds hedge their positions. The first funds at the time were also relatives of the short funds alive today. Hedge funds are another type of investment. Hedge funds are pooled funds and then adopt various strategies to earn returns for their investors. This method of collecting funds in a particular area helps their customers obtain the highest return in the shortest time. Besides, to achieve high returns, the investment source of hedge funds is mainly liquid assets. Then the fund can quickly profit from one investment and transfer these funds to another promising investment.
Hedge funds here are more inclined to use the principle of leverage or borrow funds to increase returns. However, this strategy also has risks. Although some funds do outperform the market over time, it is difficult to identify them in advance, making it impossible for retail investors or novice investors to use them. The funds of the head of the household are often subject to certain restrictions. When their funds’ liquidity has restricted the crisis, it is difficult to promptly recover the funds, resulting in the investors in losses. In the 2008 financial crisis, many highly leveraged companies were hit hard.
On the other hand, hedge funds are just another name for investment partnerships. The meaning of the term “hedging” is to protect yourself from economic losses; therefore, hedge funds aim to achieve this goal. Hedge funds invest in almost everything, including short selling and options, bonds, commodity futures, currencies, arbitrage, derivatives, and other personal stocks. Although risk factors are always involved, it depends on returns. The greater the risk, the higher the return. Regardless of whether the fund manager thinks he will provide high potential returns in a short period, hedge funds are the biggest short-term profit.
Most investors rarely choose hedge funds. On the contrary, hedge funds are aimed at qualified investors who require less SEC supervision than other funds. The so-called qualified investors refer to individuals or entities that can buy and sell securities that are not registered with financial institutions. It has also led to the regulation of hedge funds being lower than other mutual funds. Also, hedge funds’ capital scale is much larger than other mutual funds or other investment channels in terms of cost. It is because hedge funds not only charge expense ratios, but they also charge performance fees.
Definition of Private Equity
Private equity funds originated in the United States at the end of the 19th century. At that time, many wealthy private bankers used the introduction and arrangement of lawyers and accountants to use their funds in riskier oil, steel, railways, and other emerging industries. The individual investors entirely determined this type of investment without any special organization. Organizing was the embryonic form of private equity funds at that time.
A private equity fund refers to any high-net-worth individual investing in a company to obtain company equity investment capital. These funds are used to expand the firms’ operating funds, strengthen the balance sheet, or divert new technologies to help the enterprise to increase production. So, these operating funds have never been quoted in public transactions. These institutional investors and qualified investors are an important part of any company’s private equity. They can and could afford large amounts of capital for a longer period without risk. In general, turning a public company into a private company can be achieved through private equity.
Private equity funds are like venture capital companies in that they invest directly in companies, mainly by purchasing private companies. Although sometimes, they will buy shares to seek control of publicly traded companies. They will often use leveraged buyouts to acquire companies that are in financial trouble. Therefore, private equity funds are different from hedge funds that focus on short-term interest rates. Private equity funds focus more on the long-term potential of the portfolio of companies they own or acquire.
Once the private equity fund has acquired or controlled its rights and interests, the next step is to simplify operations or expansion by changing the management, thereby improving its structure. Of course, the goal must be to sell the company through a private sale or an IPO. Profit in the stock market. Besides fund managers, private equity funds usually have a special group of people to assign them to manage the company to be acquired to achieve this goal. Their ability to invest is to focus on the longer-term, looking for investment profits to mature within a few years, rather than focusing on the short-term fast interest rates of hedge funds.
Hedge Fund vs. Private Equity
- Time Frame
When we talk about private equity funds and hedge funds, the first step we should discuss is the period of their investments. Because these assets can provide investors with good investment returns in a short time. But hedge fund managers are more inclined to liquid assets so that they can quickly move from one investment to another. On the contrary, private equity funds do not seek short-term income. They will prefer to invest in companies that can provide substantial profits in the long term. The difference is that they are not interested in acquiring or operating companies, nor are they interested in companies that need to turn losses into profits.
Interestingly, private equity firms usually obtain controlling stakes in the companies that they invest in. The controlling shares are acquired through a leveraged buyout. After obtaining controlling equity, private equity funds will begin to take some corresponding measures, including changing management, expansion, and simplified operations to improve its performance. Because their goal is that when the company starts to profit, they will sell their equity to obtain a considerable profit. Although hedge funds’ investment may last for several years, they will mainly focus on realizing bank profits as soon as possible and then turn to the next profitable investment. In contrast, the average investment period of private equity funds is five to seven years.
- Investment Structure
Regarding the investment structure, most hedge funds are open-ended, and their structure follows the convention that there are no restrictions on the transferability of funds. It means that investors can constantly increase or choose to redeem the shares they have invested in the funds at any time. Also, the assets involved in hedge funds are market-to-market. However, private equity funds are different. Private equity funds are closed-end funds. Their structure must follow the convention that when funds are put into the fund, no action can be taken after the initial period has expired, including the investment of new funds. In other words, the current market cannot be easily determined or transferred within a certain period.
The way of compensation in private equity funds and hedges funds are also different. For private equity investors, a 2% management fee and 20% incentive fee are usually charged. But for investors in hedge funds, the price will be at a high-water mark. In this way, each investor’s net asset value varies according to their investment time, compared with the rise and fall year-on-year.
Here is an example to show that we assume that B invests in hedge fund ABC. The net asset value of B investment is $500. If in this year, its net asset value rises to $520, the hedge fund will have the right to get an incentive of $20. If the fund’s net asset value drops to $470 and then rises back to $490, the hedge fund will not be entitled to any rewards because the high-water mark of $500 has not been broken.
But as far as private equity is concerned, it has a barrier rate rather than a high-water mark. Private equity funds will only receive an incentive fee after exceeding this threshold. For example, if the threshold rate is 10% and the annualized return rate is 7%, no incentive fee will be charged to investors. On the other hand, if the annualized return rate is 12%, it will have the right to charge investors an incentive fee of the full 12% of the return.
- Lock-In and Liquidity
Regarding liquidity and lock-in, hedge funds, like private equity funds, usually require large balances. Here, each investor’s deposits range from US$100,000 to US$1 million or even higher. Then, hedge funds may lock up these funds for a period, usually a few months to a year or even more. During this time, investors cannot withdraw this part of the funds. During the lock-up period, foundations can allocate their funds to their strategic investments. This process takes a certain amount of time. However, the lock-up period for private equity funds will become longer, for example, three, five, or seven years. It is because that the liquidity of private equity fund investments is low, and it takes time for the invested company to turn from a loss to a profit.
Although investors in private equity funds promise to use the fund within the relevant period, investors in hedge funds usually lock in the fund only at the very beginning. But after the initial stage, hedge funds are usually provided by quarterly or semi-annual liquidity. However, even if the credit crisis has subsided, the suspension of fund redemptions through hedge funds, the suspension of net asset value determination, and other liquidity management measures are still the top priorities for hedge fund managers. Therefore, hedge fund managers are implementing a new liquidity management tool called a lock-in period.
Therefore, to better match investors’ liquidity rights, which is the redemption power and the liquidity of the underlying assets, many hedge fund companies choose to lock the assets for an extended period. Moreover, some hedge funds’ lock-up period has now been extended to three to five years, which is the same as the investment period of traditional private equity funds. Recently, the US Securities and Exchange Commission has adopted mandatory registration requirements for hedge fund managers. However, this requirement does not apply to investors whose funds have been locked for two years or more. However, to avoid being inspected by the SEC, many hedge funds have tried to extend the lock-up period to more than two years.
- Investment Risk
Besides, the level of risk between hedge funds and private equity funds is also vastly different. Even if both conduct joint risk management by combining higher-risk investments with safer investments, the hedge fund will inevitably accept higher risks to obtain the maximum profit in the shortest period.
On the other hand, the risk levels of hedge funds and private equity funds are also quite different. Both will offset their high-risk investments through safer investments. However, hedge funds tend to have higher risk returns because their goal is to obtain high returns in the short term. But it is difficult to generalize the level of risk because each fund will have some differences according to their investment strategies.
- Lifestyle and Culture
Regarding hedge funds and private equity funds working hours, the practitioners work approximately 60-70 hours of work per week in the area of private equity funds. However, the market working hours of hedge funds are more consistent. In private equity fund investment, their trading hours will fluctuate with the increase in trading activities. When the private equity transaction enters the final stage, there is a high probability that the staff will need to stay in the office all day and night and be on standby at any time. But in hedge funds, the number of hours employees work may increase with the earnings season.
In the ‘large funds’ in the two industries of hedge funds and private equity, it is expected that there will be more than 80 hours a week for similar investment banking business. Although the pressure on private equity funds comes from transaction deadlines and negotiations with other parties, the pressure on hedge funds comes from the fact that the market is not friendly for investors.
Besides, the culture of private equity is remarkably like that of investment banking. Both of them have similar procedures and similar staff. They all belong to the type of high achievement or hard work. In hedge funds, if they can generate high returns in a short period, the background and funds of investors can be ignored. So, this also leads to the diverse culture and backdrop of their founders and portfolio managers.
- The Nature of Work
As private equity’s junior staff, their daily tasks include transaction procurement, review of potential investments, valuation, financial modeling, and portfolio companies’ monitoring. At the same time, the junior staff should assist their upper level in additional acquisitions, prepare portfolio company sales, coordinate due diligence on potential transactions, edit NDA documents, other transaction documents. At the same time, the junior staff should assist their upper level in additional acquisitions, prepare portfolio company sales, coordinate due diligence on potential transactions, edit NDA documents, other transaction documents. Besides, the practitioners need to meet with bankers, lawyers, lenders, and other industry contacts to prepare for the fundraising process, the marketing materials, etc. All of these belong to the daily work of the practitioners of private equity funds. Employees working in the field of private equity funds must be proficient in working with Microsoft working documents. During this period, you need to maintain a critical attitude to find out the transaction’s problems. It is a job that requires effort and time.
Compared with private equity funds, the daily tasks of traditional hedge funds are two types. They are research and analysis. Compared with private equity, hedge funds are short-term profitable, fast-paced, no transactions, and portfolio companies that they invest in do not exist in the same way. Therefore, employees need to spend a lot of time on investment information and investment preparation. First, you need to put forward ideas and use the research model to show the team’s opinions. After completing the view’s output, the portfolio manager will review and review the fund’s issues and then decide whether to invest in this hedge fund.
The only thing in common is that both private equity funds and hedge funds use valuation and financial models. But on average, due to longer holdings, the granularity of financial models in private equity funds is finer.
- Performance Evaluation and Realization
The performance of private equity is measured in terms of the internal rate of return (IRR). Usually, the lowest barrier rate private equity funds. Then, in hedge funds, the returns are immediate, sometimes to get more incentive fees, and their performance is measured against benchmarks.
The performance of private equity funds is generally achieved after reaching the barrier rate. It is the reason why the early private equity companies’ performance reported is mostly negative. However, the performance of hedge funds can continue to grow while investing in assets.
- Hedge Funds and Private Equity Careers, Promotions, and Salaries
Just as the work in private equity funds is more structured and hierarchical, private equity funds also have a clear definition of the hierarchical structure, starting with analysts. Senior assistants, vice presidents, directors or heads, general partner, and the job’s content also changes with the change of position.
In the beginning, employees need to spend more time dealing with digital issues, editing them into documents for analysis, and then conducting quarter transactions. However, most of them will become managers, negotiators, final decision-makers, fundraisers, or company representatives when they are promoted. During this period, the company will judge whether employees can enter the next level according to specific criteria. Almost everyone will stay at one level for a specific time.
However, compared with private equity funds, the promotion process of hedge funds is more random. There are fewer positions in hedge fund companies, and the nature of their work does not vary greatly depending on the content of the position as in private equity.
In the company, the junior level includes junior analysts, analysts, and research assistants. These positions’ job content is to sort out the numbers and build investment documents by analyzing the numbers. However, even senior analysts, department heads, and portfolio managers must perform some of the work content at the junior level. On the other hand, as a project manager, to complete the same work content as juniors, they have other tasks to finish, for example, fundraising, risk management, or investment logistics management. There is no fixed time limit for career development in hedge funds. Some people may reach project manager in just a few years. However, some people will find it difficult to get a promotion after reaching senior analysts.
Generally, private equity funds are used to acquire shares in public limited liability companies and convert them into private companies or invest in private companies to control their asset management funds. Besides, private equity funds’ purpose is to acquire public companies, expand, and strengthen the organization’s balance sheet. Hedge funds raise funds from investors and invest in private companies that can take risks and make profits in the short term. Regarding choosing hedge funds or private equity funds, employees need to make appropriate choices based on their professional situation, abilities, and future work plans.
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